Balance Sheet Network Analysis of Too-Connected-to-Fail Risk in Global and Domestic Banking Systems
Introduction (via Jorge Chan-Lau)
The recent financial crisis experienced in 2008/9 has raised concerns on the adverse consequences associated with externalities inherent in the financial system. One particular concern associated with the increased pace of globalization and financial integration is interconnectedness risk, or the Too-Connected-to-Fail (TCTF) problem. The TCTF problem, in turn, brings up issues on how best to regulate TCTF institutions and how to ensure they fall within the perimeter of regulation.
A rather simplistic characterization of the TCTF problem is that the failure of one institution could lead to successive rounds of failures of other institutions in the system. The failure cascade is prompted by inter-institution exposure from the existence of direct and indirect linkages between the institutions in the system. The direct linkages arise, for instance, from balance sheet claims that expose one institution to the default of other institutions, or from the reliance on credit lines that can be withdrawn abruptly without enough advance notice. The source of indirect linkages could be through derivatives contracts and securities with market values linked to the failure of an otherwise unrelated institution. Prudential regulation and systemic risk surveillance, therefore, call for the development of methods useful for assessing TCTF risk as emphasized recently by the Bank for International Settlements (BIS), the Financial Stability Board (FSB), and the International Monetary Fund (IMF) (2009a, b). One such method, balance sheet-based network analysis, offers a practical way to analyze risks arising from linkages associated to direct exposures related to the balance sheet of financial institutions. The method is suitable for the type of data typically available to financial supervisors in most jurisdictions, and the type of cross-country banking data available from institutions such as the BIS. When secondary market prices are available, network analysis complements assessments based on market-based methods.
This paper first illustrates the use of balance sheet-based network analysis to evaluate interconnected risk from direct exposures across banking systems in advanced and emerging market country economies. The analysis, based on BIS cross-country bank claim data for reporting jurisdictions, suggests that the main sources of risk in the global banking system are shocks that could impair the solvency of banks based in the United States and the United Kingdom. Among BIS reporting jurisdictions in Latin America, it appears that the banking system in Brazil is the most resilient to global shocks while the banking system in Chile may be more exposed to funding risk from Spanish banks.